Russia Economic Outlook

November 28, 2017

Preliminary GDP results for Q3 revealed that the recovery lost steam, after growth had shot up in Q2. Although details of the release are still outstanding, softer industrial output in part likely drove the slowdown, while household spending is expected to have remained buoyant thanks to firmer confidence and rising wages. More recent indicators suggest a mixed start to the fourth quarter. Industrial output recorded zero growth in October. The Ural oil price, however, shot up in the same month—boding well for export revenues. The government will meet with OPEC and non-OPEC nations on 30 November to discuss prolonging output cuts past the current deadline of March 2018. It is widely expected that the deal will be extended, although some analysts speculate that the announcement could contain new provisions linking the size of production cuts to the health of the oil market. Several Russian oil producers have expressed discontent at an extension of the deal, as new oil fields are expected to come online next year.

Russia Economic Growth

The gradual recovery is expected to continue next year, as higher oil prices and more accommodative monetary policy support growth. However, fiscal tightening and constrained oil production will likely keep growth moderate overall. In addition, tightening sanctions are a key downside risk to the forecast. Met the why particular Consensus Forecast panelists upgraded their 2018 forecasts for the Russian economy this month and see GDP expanding 1.9% in 2018, 0.1 percentage points above last month’s forecast. In 2019, growth is seen broadly stable at 1.8%.

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Russia Economy Overview

Economic Overview of Russia

Following the collapse of the Soviet Union, the first decade of transition from a centrally-planned economy to market economy was disastrous for Russia: nominal gross domestic product (GDP) fell from USD 516 billion in 1990 to USD 196 billion in 1999, which represented a plunge of over 60%. In an attempt to address the economic turmoil and follow the recommendations from the IMF, the Soviet government began to privatize many Russian industries during the 1990s. Important exceptions were, however the energy and defense sectors.

The devaluation of the Russian ruble in 1998—after the financial crisis known as the ruble crisis—together with the uninterrupted upward trend that oil prices experienced in the period from1999 to 2008 propelled the Russian economy—heavily reliant on its energy sector exports—to grow at an annual average rate of 7%. Russia was among the hardest-hit economies by the 2008-2009 global economic crisis: the economy plunged 7.8% in 2009 as oil prices plummeted and foreign credit dried up. The economic contraction was the sharpest since 1994, but no long-term damage was caused due to the government and Central Bank’s proactive and timely response to ring fence key sectors of the economy, in particular the banking sector, from the effects of the crisis. As a result, Russia’s economy began to grow again and increased 4.5%, 4.3% and 3.4% in 2011, 2011 and 2012, respectively, before slowing to 1.3% in 2013 and 0.6% in 2014.

The Russian economy experienced two major shocks in 2014, narrowly avoiding recession with moderate growth of 0.6%. The first shock was the sharp decline in oil prices during the third and fourth quarter of 2014, exposing Russia’s extreme dependence on global commodity cycles. After fluctuating within a tight band near USD 115 per barrel from 2011-2013, crude oil prices ended 2014 at less than USD 60 per barrel. The second shock was the economic sanctions resulting from geopolitical tensions, which negatively affected investor appetite for Russian investments. Capital flights and high inflation compound Russia’s economic woes as the economy registered the steepest contraction since 2009 contracting 3.7% in the full year 2015. Forecasts are pointing to an end to the recession coming soon in 2017.

Inflation has been falling rapidly since August 2015, when it reached a peak of 15.8%. Along with the fall in inflation, Central Bank lending rates have been reduced. Russian bonds and equities are performing well against those of other emerging markets and a modest recovery in oil prices has bolstered economic sentiment.

Considering that the price for Urals oil will average USD 38 per barrel in 2016, the Central Bank expects the economy to contract between 0.3% and 0.7% this year, which is less than the Bank’s previous estimate that saw the economy contracting between 1.3% and 1.5%. The Bank expects the economy to expand at a rate of between 1.1% and 1.4% in 2017, assuming that Urals oil prices average USD 11 per barrel. Previously, the Bank had expected the price for Urals oil to average USD 35 per barrel and had projected economic growth rising to within a range of minus 0.5% and plus 0.5% in 2017.

Following the economy’s collapse in 2015, analysts surveyed by Met the why particular expect the Russian economy to continue contracting in 2016, although at a more moderate pace. Met the why particular Consensus Forecast panelists project that Russia’s GDP will fall 0.7% in 2016, which is up 0.1 percentage points from last month’s forecast. Panelists expect the economy to expand 1.3% in 2017.

Russia’s Balance of Payments

Russia’s current account records regular trade surpluses largely due to exports of commodities such as crude oil and natural gas. From 2011 to 2014, Russia’s average current account surplus was USD 66.8 billion, reaching a peak in 2011 at USD 98.8 billion.

Russia’s balance of payments suffered a significant terms-of-trade shock in the fourth quarter of 2014 as a result of falling oil prices, which were, in part, offset by a drop in imports. Simultaneously, geopolitical uncertainties and related sanctions in 2014 resulted in large capital outflows, further deteriorating Russia’s BoP. Private sector capital outflows increased from USD 60.7 billion in 2013 to USD 130.5 billion in 2014. During the same period, capital and financial accounts of the Russian Federation fell from a deficit of USD 45.4 billion to a deficit of USD 146 billion (2.2% and 7.8% of GDP, respectively).

Russia’s economy registered the steepest contraction since 2009 last year as a combination of external factors—such as a plunge in oil prices and international sanctions—coupled with structural weaknesses took a heavy toll on growth. The economy contracted 3.7% in the full year 2015, which contrasted the meagre growth registered in the previous year. However, the contraction in the Russian economy in the second quarter of 20167 was the slowest since the recession began in late 2014. Comprehensive data showed that GDP contracted 0.6% annually in Q2, which came in above the 1.2% decrease recorded in Q1. Although industrial production shrank in September, falling at the fastest pace seen in 8 months, it is expected to expand slightly in 2016 after suffering the worst contraction in six years in 2015.

Russia’s trade structure

Crude oil, petroleum products and natural gas comprise roughly 58% of total exports, iron and steel represent 4% and other mining sector related exports including gems and precious metals account for about 2.5%. Sales to Europe represent over 60% of total exports while Asia has an export share of roughly 30%. Russian exports to the United States, Africa and Latin America combined represent less than 5% of total shipments.

In August of 2015, Russian exports amounted to USD 25.0 billion, which marked a 39.7% contraction in annual terms. This marked the 11th consecutive contraction at a double-digit rate. Imports totaled USD 16.5 billion, which marked a 34.7% year-on-year contraction.

Russia’s trade surplus is narrowing rapidly. Russia’s trade surplus narrowed to USD 4.4 billion in August of this year, which came in dramatically below the USD 8.8 billion registered in the same month last year and the USD 16.2 billion the prior year. August’s result prompted the 12-month rolling surplus to decrease to USD 99.5 billion, the smallest accumulated surplus in over a decade. The fall in the trade surplus continues to reflect the free fall that Russian exports have registered over the last few years.

Following a period of heightened volatility, oil prices have recently stabilized especially since the extraordinary meeting of the OPEC Conference in Algiers in the last week of September, which concluded with a commitment to freeze oil production at between 32.5 and 33.0 million barrels a day. Analysts expect the commitment to be honored by most members at OPEC’s official meeting in November where non-OPEC oil exporters are also encouraged to sign on the dotted line. The re-establishment of OPEC’s price leadership prompted global oil prices to spike, including for Urals oil. On 30 September, the price for Urals oil settled at USD 46.3 per barrel, which was 4.6% higher than at the end of August. Urals oil has also recovered from the lows registered earlier this year and was 31.8% on a year-to-date basis.

Russia’s Monetary Policy

The Central Bank of Russia (Bank Rossii), founded in 1990, has several responsibilities in compliance with the Russian Constitution and Russian Federal Law: maintaining the value and stability of the ruble, overseeing Russian financial institutions (including acting as a lender of last resort), managing Russia’s foreign reserves and foreign exchange, and setting short-term interest rates, which is one of the main instruments of the bank’s monetary policy implementation.

Low oil prices and sanctions shocks to the Russian economy resulted in the ruble losing 46% of its value against the U.S. dollar in 2014, prompting policies from the Bank Rossii aimed at stabilizing the financial system. Bank Rossii raised its key interest rate in December 2014 by 650 basis points to a lofty 17% to curb runaway inflation caused by the weakened ruble (core inflation reached 11.2% in December 2014, year-on-year). Bank Rossii spent USD 27.2 billion in October 2014 and USD 11.9 billion in December of the same year on interventions to support the ruble.

Russia’s Central Bank gradually reduced interest rates over the course of 2015, starting the year at 17.00% and reduced to 11.00% by July. Interest rates were kept steady for nearly a year until June 2016 when they were cut by 50 basis points to 11.50%. In making the decision to cut interest rates, the Central Bank indicated that authorities were more confident about the evolution of inflation and noted the positive results of a drop in inflation expectations and decreased inflation risks against a backdrop of their slowly but surely recovering economy.

Since then there has been a noticeable drop in inflation, which drove the Bank to cut rates in September 2016 from 11.50% to 11.00%. Authorities did however state that in order to cement a sustainable fall in inflation, “the current value of the key rate needs to be maintained till end-2016 with its further possible cuts in 2017 Q1-Q2.” Considering its decision, the Bank remains confident that with a still relatively-tight monetary policy, inflation will fall to 4.5% in Q3 2017 and decrease further toward its 4.0% target at the end of 2017. The bank also indicated that it will hold off from further monetary easing until the first or second quarters of 2017.

Russia’s Exchange Rate Policy

On 11 November 2014, Bank Rossii un-pegged the ruble from a dual-currency (U.S. dollar and euro) basket band, ending two decades of exchange rate controls and moving Russia to a free-float exchange rate system. The Central Bank also ended the regular interventions with the ruble, but signaled that it remained committed to intervening in support of the Russian currency in case there were risks to financial stability. As the ruble continued to slide against the greenback because of falling oil prices and higher uncertainty among investors, the Central Bank decided to continue intervening in the foreign exchange market, costing the Central Bank hundreds of millions per day.

The value of the ruble first began to fall in early 2014 after several years of an exchange rate of roughly 30 RUB per USD, as the country was acutely affected by weak economic growth, high geopolitical risks following the annexation of Crimea and the outbreak of war in Ukraine. However, it was with the collapse of oil prices at the end of 2014 when the ruble’s value could not defy gravity and thus began its free fall against the U.S. dollar, with the currency bottoming out at 68.5 RUB per USD on 16 December. Throughout 2015, the Russian ruble has been on a roller coaster. High volatility and strong fluctuations in oil prices have weighed heavily on the country’s currency. The beginning of 2015 saw strong volatility in the foreign exchange market, but the Russian currency stabilized within a corridor of 50 to 60 RUB per USD at the end of the first half of the year. There was another episode of strong volatility at the outset of second half of the year and, on 24 August, the Russian currency closed the trading day at 70.9 RUB per USD, which was even lower than the aforementioned low point of the December 2014 ruble crash and represented a new all-time low. The sharp drop in August was primarily a response to falling oil prices and rising fears regarding the effects that the shockwave caused by China’s stock-market crash could have on the global economy. The ruble closed 2015 at 72.9 RUB per USD—a 30% loss in value compared to the end of 2014.

Fluctuations of the Russian ruble are largely driven by the price of oil, which along with gas, is Russia’s main commodity export. The currency took a dramatic fall to an all-time low of 82.4 RUB per USD on 21 January 2016, as oil prices fell to lows not seen in over a decade. It has gradually stabilized between 60 and 70 RUB per USD as the economy has improved and oil prices have crept back up since January 2016.

Russia’s Fiscal Policy

Since the country’s 1998 debt crisis, a nearly decade-long environment of favorable commodities prices (particular in the energy sector), a relatively weak ruble and tight fiscal policy allowed Russia to run budget surpluses from 2001 to 2008 until the global financial crisis hit.

Russia depends heavily on its energy exports. In fiscal year 2008, oil and gas revenues reached a peak, accounting for half of the Russian federal budget. However, since the global financial crisis hit the country in 2009, the Russian economy began to run fiscal deficits. In 2012, 2013 and 2014 Russia ran budget deficits representing -0.02%, -0.7% and -0.6% of GDP, respectively. The exception was the year 2011, when the Russian budget incurred a 0.8% of GDP surplus.

Low oil prices and a collapse in domestic demand and imports as the economy fell into recession decimated fiscal revenues in 2015. In fact, the impact of low oil prices on Russia’s fiscal revenues raised questions about the country’s long-term economic prospects as well as fiscal sustainability. With the decline of energy prices and the Russian government's dependence on energy revenues to fund its budget—revenues from oil and natural gas represented around 52% of the Russian budget—forced the Russian government to rethink its fiscal policy. The Finance Ministry announced in early September 2015 that it had decided to suspend the fiscal rule—a law designed to limit government spending.

The fiscal rule went into effect in 2013 to prevent the government from wasting windfall oil revenues and instead divert them into rainy-day funds. The rule also aimed to limit government expenditure to projected non-oil revenues, oil revenues calculated using long-term historical oil prices, and a fiscal deficit of at no more than 1.0% of GDP. At the time the rule was created, Russian authorities were concerned that the income generated from rising oil prices would encourage pro-cyclical spending. However, within the context of weak economic growth and oil prices at just half the level observed in 2014, Russia faced the opposite problem.

Because the budget rule limits government spending to long-term historical oil prices, if the law were to continue into 2016, it would have implied a reference price higher than the one that was forecast for 2016—which was an average USD 50 per barrel.

Officially, the fiscal rule was suspended temporarily. Some advisors, among them former-Finance Minister Alexei Kudrin, voiced support for suspending the rule, at least for a year. Moreover, in addition to the suspension of the fiscal rule, the government also announced a transition from a three-year budget plan to one-year budgeting. The three-year budget plan was designed to force the government to take a medium-term approach and avoid making unsustainable pledges. All in all, the changes to the budget process paved the way for a more accommodative fiscal stance in an effort to mitigate the low oil prices and weaker economic growth.

Some analysts suggest that, with sizeable reserves and low public debt, Russia can afford to run a modest fiscal deficit without imperiling fiscal sustainability. The fiscal deficit ended at 2.8% in 2015.

Russia has two fiscal buffers, the Reserve Fund and the National Welfare Fund (NWF), both of which have been under pressure as a result of deteriorating economic conditions. The Ministry of Finance indicated that the budget deficit projected for 2015 (RUB 2.7 trillion, equivalent to 3.8% of GDP) would be covered by the country’s Reserve Fund, rather than by raising debt. Unfortunately, the government was unable to sustain that deficit due to the inability to fund it. Due to international sanctions, the government has been unable to borrow from abroad. The government allowed for increased discretionary use of NWF resources in December of 2014 in order to help stabilize the financial system. The Russian government had no choice but to continue to draw down on the NWF.

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